Monday, March 9, 2009

CDS: The Equity Connection Today

CDSs are equity substitutes carried at zero margin, masquerading as credit instruments. They create a feedback loop mechanism to equity markets that results in reducing volatility when things look good and increasing it when they don't. In other words, they work as risk amplifiers and not as risk attenuators.

... we have the potential for a financial viral disease of pandemic proportions. The CDS market is so new that it has never been tested on the downside of the credit/business cycle. We simply have no inkling of how it will behave under real life duress, when major credit events occur with increased frequency and magnitude.

I am not re-posting this to reap accolades for accurate prediction abilities. Rather, I want to stress two points relevant to today's situation:

a) All CDS trading counterparties are now - finally! - required to post margin, i.e. collateral. Furthermore, what was up to now a strictly OTC business is about to become significantly more organized and transparent through the involvement of established futures exchanges (ICE and CME are both vying for the business).

Thus, two of the major factors that previously allowed for unbridled speculation and opaque practices are being removed. That's a good thing, but it is definitely putting pressure on participants (and prices) in the short run.

b) CDSs acting in their role of phantom equity are now in reverse mode, causing substantial downward pressure on share prices - just as they artificially boosted share prices on the way up.

In my opinion, the two points taken together go a long way in explaining why CDS's for GE and Berkshire Hathaway are trading at puzzling levels, similar to those for much less creditworthy companies. For example, even though Warren Buffet's company has $25.5 billion of cash on hand and a AAA credit rating its CDSs "cost as much as those of KB Home, the homebuilder that lost money for seven consecutive quarters."

Things are just as bad for GE. "Sellers of credit-default swaps tied to the debt of General Electric Capital Corp. for five years yesterday demanded 16.5 percent upfront, in addition to 5 percent a year, according to broker Phoenix Partners Group. That means it costs $1.65 million initially and $500,000 annually to protect $10 million of obligations. The cost was $446,000 a year two weeks ago."

But at long last somebody is putting two and two together:CDSs create "phantom" short (or long) stock positions. From the same Bloomberg article:

"Because an average of just 1,550 Berkshire shares are traded on public exchanges, it’s difficult to borrow the stock to bet against the company through short sales. So, speculators may be buying credit-default swaps to hedge against equity losses, said Backshall of Credit Derivatives Research. "

Obviously, this kind of trading is not restricted to shares with low trading volume - in fact, I believe the exact opposite is happening, given the opportunities for arbitrage and manipulation in CDS - equity spreads.

The finance tail is, once again and quite noticeably, wagging the economy dog. That's pretty dangerous stuff for a nation - and even a President - that remain in thrall of daily index gyrations.

Note: A reader already had a question which perhaps many of you share:

"Would it be possible for you to elaborate a bit further on how CDS put pressure on stock prices today?"

Sure.

Here's one way:

Let's say you are a bank, insurance co. or hedge fund and have already sold CDSs (i.e. written credit insurance) in the past, on XYZ Motors debt. You now wish, understandably, to reduce your exposure.

You can:

a) Buy offsetting CDSs (not at all easy these days, very expensive and fraught with counterparty issues - remember, this is strictly OTC business still) and/or,

b) Short XYZ stock at an appropriate correlation ratio.

Even if you manage to accomplish all you need with option (a), whoever is selling you the CDS will need to hedge - assuming he's opening a new position and not closing an old one. Most likely hedge? Shorting XYZ stock.

The above example also applies if you are only doing "dynamic hedging" and not reducing overall exposure. Effect is the same, in the end - pressure on common stock of XYZ.

Come to think of it, there is a very intriguing aspect to this situation. If the current CDS mess is - somehow - quickly resolved on a comprehensive level (one example would be through migration of all the business, including open positions, to an established exchange and thus common clearing), then we are looking at lots and lots of short positions that may not be exactly necessary... .... .... fill in the blanks.

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"Would it be possible for you to elaborate a bit further on how CDS put pressure on stock prices today?"

Sure.

Here's one way:

Let's say you are a bank, insurance co. or hedge fund and have already sold CDSs (i.e. written credit insurance)in the past on XYZ Motors debt. You now wish, understandably, to reduce your exposure.

You can:a) Buy offsetting CDSs (not at all easy these days and very expensive) and/or,

b) Short XYZ stock at an appropriate correlation ratio.

Even if you manage to accomplish all you need with option (a), whoever is selling you the CDS will need to hedge - assuming he's opening a new position and not closing an old one. Most likely hedge? Shorting XYZ stock.

The above example also applies if you are only doing "dynamic hedging" and not reducing overall exposure. Effect is the same, in the end - pressure on common stock of XYZ.

It took years in court to clear up leveraged positions on viatical contracts escow covenant margin call's. The asset's leveraged where sold and luckily we settled before this really hit the Dow to obvious capital migration. We settled for regional stock in the said bank. The point was and is property right's of contract and what part of the food chain you are anyway. Deregulation had nothing to do with balance sheet violation's and the Court agreed as such. The point was and is balance sheets did not meet Mr. Markets wake up call and obviously where sitting on regional stock and cash until perception meets reality which is basically looking in the mirror at yourself. Who can you trust and which ledger sheet is looted before they eat your lunch. There in prison eating state provided food. I kept my day job and it will take a long time to trust any model not based on priciples on sound capital management. CDS are a ticket to incarceration and balance sheet malipulation's of internal intent IMO. Value of contract is essentialand shorting may be fine with some but how far can the rats swim in the long run is the real question?

cottonblogginJapan used to have a postal savings system. It had four times as many accounts as there were savers, because they were using it to avoid taxes. The Japanese government closed it to force money back into the banking system, bond market, property market, and share market, at the top of the boom.

I fail to see why migrating to an exchange would resolve any of the existing CDS problems. Future problems would be mitigated by requiring collateral but many CDS writers of existing contracts will not be able to come up with the required collateral triggering the problem we are all awaiting. The only solution I see is "force majeure" annulling these contracts or something like Scholes suggested where they are settled on a median price.

Note this is an additional factor restricting the government from forcing any large institution GM, Chrysler, Citi etc. into bankruptcy.

Yes, a short covering rally lollapalooza like we have rarely if ever seen before could occur as a result of a few key changes in the CDS and naked shorting spheres. I hope that's what you are suggesting, otherwise I have no idea what you are hinting at.

We're getting close to a point in time (if not perhaps price) where, at least technically a big countertrend rally ensues. If the authorities make some well timed adjustments well that could make for retrace rally for the ages. Having said that, I'm not counting on it.

Hell says it's not about sectors. No, but various sectors will certainly be affected.

Moving the CDS business from OTC to one or more exchanges would do the following:1. Increase transparency of dealings and open positions.2. Permit increased regulation and oversight, particularly on position limits.3. Resolve counterparty risk issues.4. Cut down rampant speculation, particularly by non-qualified participants.

If existing OTC positions are also migrated to exchanges - I think this is crucial - then a massive netting between counterparties would result beforehand, cutting down nominal amounts outstanding by AT LEAST 50%.

Yes, there are many difficult issues surrounding this process. And it will be painful for some. But I believe it is absolutely necessary.

By the way, I have some considerable experience in OTC business and the migration to more regulated dealing platforms. It is usually beneficial, but it must be handled carefully.

Thanks so much for responding on the conversion to exchange ramifications. I agree entirely that it should happen. It seems, unfortunately, from what you said that the issue I underscored will still be troublesome. You note that perhaps 50% of positions will be found to be nominally offsetting and consequently the outstanding open contracts reduced. That still does leave the other 50% and in addition these were offsetting to begin with so would cancel out in a bankruptcy. These are not arguments against conversion but a concern about the larger problem existing unreserved contracts represent. That is why Scholes and I were arguing for some sort of fiat regulation. I still think "force majeure" is probably the best solution for those contracts still outstanding and insufficiently reserved but I would very much like to know what you think. SS

I, too, agree that under-reserved CDS pose a serious problem. It's equivalent to an insurance co. selling casualty insurance with a very thin - or even non-existent - capital base.

In fact, this was ALWAYS the major structural problem with CDS: being able to assume massive risks without posting proper margin/collateral.

But, as with any insurance transaction, BOTH sides are to blame: the insurer (CDS seller) who sold insurance without proper capitalization and the insured (CDS buyer) who bought insurance from a fly-by-night shop.

There are, of course, many CDS transactions that are perfectly fine - sensible seller, good faith buyer. So, we cannot force everyone to suffer with a blanket force majeure. In fact, CDSs have become a very important hedging tool, so if we cancel everyone out we will definitely see unwelcome pressure elsewhere (common stock?).

Here's an alternative:

a)Net all positions - down to customer level.b)Set margin requirements, but not at onerous levels.c)Stress-test 80-90% of the remaining positions to gauge who can and who cannot bear the margin requirements.

It is likely that the weak players will be concentrated in the hedge fund/private equity area. That's not your average Joe Investor - it is MOSTLY very wealthy individuals and some SWF money. They can certainly afford the loss. And those who bought insurance from them should have known better.

Force them to work things out amongst themselves and/or let them fail. Settle or die, would be the rule.

Thanks so much, what an excellent solution. The only fear I still have is that some banks and insurance companies (even otherwise sound ones) may be the counterpart to these transactions, e.g. have purchased insurance from unreserved sellers and this loss will go further into pushing them under. I suspect this is why the government is so far juggling balls to keep every major entity from going into bankruptcy.

Hope your right though and the problem is smaller than I think. You're doing great work here. All the best.

Would it not be the case that the trip to $1 a share ameliorates the problems with the short burden on the stocks resulting from hedging of CDS exposure?

In other words, you hedge CDS liability by shorting the stock. The stock gets hammered down to almost nothing. You close the short and now have a reserve as to the exposure you have from the CDS liability.

IF (big IF) the company survives the low test of its share price without ratings and market cap issues requiring a payout on the CDS, then with the artificial burden on stock price removed, it should proceed upward.

And the trip to the bottom took an unbacked CDS liablity position and changed it to one backed by some value gained in the short's trip to the bottom.

OK, assume all CDSs are transfered to an exchange. What exactly happens when the issuer gets a margin call and cannot add funds? He will be forced to sell all his puts and is left with a debt to the exchange that will have to make someone else take over the long side. That someone else now has to buy puts to hedge. The same instruments just switch hands.

Off an exchange the issuer can get away with having too few puts, because of lack of supervision. On the exchange that will not be possible. Result: More puts.

About Me

I was educated as a chemical engineer but spent almost my entire career in finance, particularly in money, FX and bond markets. The name stands for Hell-as-IOUs and the picture points to Quixotic endeavors.